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Paste Body Text Here Research Sol utions September 2009 LexisNexis ® Emerging Issues Analysis Frank Aquila and Melissa Sawyer on Contingent Value Rights - Means to an End: Using CVRs to Bridge Valuation Gaps in Public Company M&A Deals 2009 Emerging Issues 4364 Setting a deal price is often the toughest issue in any negotiation, sometimes it is the only issue. In far too many deals, that gap cannot be bridged. Innovative dealmakers have long recognized that contingent value rights ("CVRs") could be the perfect – albeit highly structured – solution. CVRs are derivative securities or contract rights that pay holders upon the occurrence of specified contingencies. While CVRs have been used in pharmaceutical and biotech M&A deals, they are not used widely in M&A deals. That could be changing because CVRs are an extraordinarily flexible tool that can be struc- tured in an infinite variety of ways to suit the facts and circumstances of a particular transaction. Although the financial, tax, legal and other aspects of CVRs can add complexity to a deal, those issues are far from insurmountable. This article suggests that CVRs should become a regular component of an M&A lawyer's arsenal and highlights certain techni- cal considerations associated with using CVRs. First, this article describes a number of potential ways in which CVRs can be used in M&A deals. Second, this article describes certain of the key characteristics of CVRs that factor into their design. I. Uses of CVRs Typically in M&A deals, CVRs fall into two broad categories: (1) performance driven CVRs and (2) event driven CVRs. A third category, financing-related CVRs, is not widely used in M&A but may have many practical applications. Performance-Driven CVRs Performance driven CVRs are linked to the issuer's performance over a certain period of time. In an M&A deal, for example, the buyer can issue performance driven CVRs to the target's stockholders, in addition to shares of buyer's common stock or cash. The CVRs could be structured in any of the following ways: (1) Hedging Instrument. The CVRs would pay out cash or securities to the target's legacy stockholders if, on the maturity date, the buyer's stock is trading below an agreed level. CVRs with this design function as hedging instruments: They guarantee a mini- mum amount of consideration per target share after a prescribed period of time, even if TOTAL SOLUTIONS Legal Academic Risk & Information Analytics Corporate & Professional Government LexisNexis, Lexis and the Knowledge Burst logo are registered trademarks of Reed Elsevier Properties Inc., used under license. Matthew Bender is a registered trademark of Matthew Bender Properties Inc. Copyright © 2009 Matthew Bender & Company, Inc., a member of the LexisNexis Group. All rights reserve d. -1 - Research Sol utions LexisNexis ® Emerging Issues Analysis Frank Aquila and Melissa Sawyer on Contingent Value Rights - Means to an End: Using CVRs to Bridge Valuation Gaps in Public Company M&A Deals the buyer's stock price drops after the deal is completed. These CVRs resemble put op- tions by giving the target's stockholders down-side protection. 1 If they are separately traded instruments, these types of CVRs will have trading values that move inversely to the value of the underlying buyer stock ( i.e. , as the buyer's stock price declines, the CVR would increase in value). Why create a hedging instrument for target's stockholders, rather than letting the market generate its own hedging techniques? Among other reasons, the target's board may not feel comfortable agreeing to a transaction that requires stockholders to obtain their own hedges because that could lead to disparate outcomes for different types of stockhold- ers. For example, sophisticated institutional stockholders are more likely than individual retail investors to have access to the knowledge and resources necessary to trade in derivatives. In addition, making the hedging instrument an official component of the deal consideration shifts the transaction costs associated with the instrument partially to the buyer and the buyer's legacy stockholders and partially away from the target's legacy stockholders. CVRs that are designed like hedging instruments could be a particularly appealing op- tion in an auction in which a potential buyer that is proposing to use stock consideration is competing with potential cash buyers. By including a CVR in its offer, the stock buyer may be able to make its offer more directly comparable to cash offers and to eliminate any concerns the target's board may have about volatility of the buyer's stock price. Such CVRs could also be used to deliver fixed value in a fixed exchange ratio deal in lieu of a floating exchange ratio/collar mechanism. Buyers should keep in mind, how- ever, that issuing hedging CVRs can result in the buyer's stock price becoming de- pressed due to trading by arbitrageurs. (2) Earn-Out Instrument. The CVRs would pay out cash or securities to the target's legacy stockholders if, on the maturity date, a business line, asset or other part of buyer that represents a legacy business of the target is performing at an agreed level. If the target believes that its future business plans are likely to generate greater value than is 1. For a good description of how a financial advisor may evaluate the pros and cons of using CVRs as hedging instruments in a particular transaction, see Goldman, Sachs & Co.'s Presentation to the Special Committee of Genentech Inc. in Exhibit (c)(2) to Genentech Inc.'s Schedule 14D-9/A filed on March 12, 2009. The presentation also cites a number of precedent merger trans- actions that used CVRs, including Wesfarmers-Coles (2007), Publicis-Saatchi & Saatchi (2000), BNP-Paribas (1999), Suez- Lyonnaise-Generale de Belgique (1998), Viacom-Blockbuster (1994) (VCRs), and Viacom-Paramount (1994). Other examples of transactions that used CVRs as hedging instruments include ViroLogic-Aclara (2004); Mannkind-Pfizer (2009); and Dow Chemical-Marion Laboratories (1991). TOTAL SOLUTIONS Legal Academic Risk & Information Analytics Corporate & Professional Government LexisNexis, Lexis and the Knowledge Burst logo are registered trademarks of Reed Elsevier Properties Inc., used under license. Matthew Bender is a registered trademark of Matthew Bender Properties Inc. Copyright © 2009 Matthew Bender & Company, Inc., a member of the LexisNexis Group. All rights reserved. - 2 - Research Sol utions LexisNexis ® Emerging Issues Analysis Frank Aquila and Melissa Sawyer on Contingent Value Rights - Means to an End: Using CVRs to Bridge Valuation Gaps in Public Company M&A Deals currently reflected in the target's stock price or the valuation multiple proposed by the buyer, the CVR would give the target's stockholders a means to participate in the future upside from the target's operations without sharing those benefits pro rata with the buyer's legacy stockholders. The CVRs simultaneously would allow the buyer to defer payments, giving the buyer time to realize synergies and manage downside risks before having to part with cash, securities or other assets. This type of CVR could help to bridge the gap between a conservative buyer's estimates of a target's future perform- ance ( e.g. , the "base case" view) and an optimistic target's expectations ( e.g. , the "op- timized case" view). This could be especially useful in transactions that require stock- holder approval for both the buyer and the target because the CVRs can provide a means for balancing the need to pay the target's stockholder a price that is at a pre- mium to its historical average stock price, while at the same time not causing the buyer to pay an EBITDA multiple that exceeds those paid in recent comparable transactions. 2 CVRs that are designed like earn-outs are complex. Among other reasons, they suffer from the same difficult issues that affect any kind of earn-out, including the fact that the parties must agree on all of the following potentially contentious characteristics of the CVR prior to announcing a deal: (1) which assets or business lines will form the basis for meas- uring the value of the CVR and what metrics and targets will be used to assess the per- formance of those businesses; (2) the maturity date; 3 (3) who will perform the relevant cal- culations and how those calculations will be tested and verified; (4) how changes in the buyer's accounting policies after the deal closes will impact the CVR's value; (5) whether and to what extent the buyer can engage in businesses that compete with the businesses underlying the CVR; (6) whether the buyer can sell or discontinue the businesses underly- ing the CVR; (7) whether buyer should be subject to any ongoing operational restrictions to preserve the value of the businesses underlying the CVR; (8) whether buyer should be re- quired to make any commitments to provide financing (including making capital expendi- tures) to, or to perform services on behalf of, the businesses underlying the CVR; and (9) to what extent value-drivers unrelated to the performance of the businesses underlying the CVR (such as the effect of an upturn in the economy generally or efficiencies generated by the buyer at the corporate parent level that have an ancillary benefit for the businesses underlying the CVR) should be "read out" of the measurement of the performance of the 2. Examples of transactions that used earn-out CVRs include: Fresenius SE-App Pharmaceuticals (2008); Onstream Media- Narrowstep (2008); and Minnesota Mining and Manufacturing/Cardiovascular Devices (1988). 3. On average, it appears the maturity dates for CVRs used in M&A transactions are between 1 and 3 years. Under the New York Stock Exchange ("NYSE") listing rules, listed CVRs must have a minimum life of at least one year.
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